Beware Surprises in Fed's Taper

The central bank has signaled a gradual withdrawal of stimulus. But Larry Summers' withdrawal from consideration as Fed chief is a reminder that public events don't always follow a script, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Larry Summers' letter, withdrawing his name from consideration to head the Federal Reserve when current chairman Ben Bernanke departs, presumably in January, is a reminder that even carefully watched, exhaustively reported, and endlessly handicapped events can produce BIG surprises.

Summers was, until his withdrawal, considered the front-runner for the job. Now, who knows?

Current vice-chair Janet Yellen? Donald Kohn, Number two at the Fed until 2010? A dark horse candidate such as Roger Ferguson, Stanley Fischer, or Jeremy Stein? Could Tim Geithner, former Treasury Secretary, be in the running, despite his frequently expressed disinterest in the job?

Something that seemed settled is wide open again. And the effects on the financial markets are certain to be far-reaching.
Can I envision anything nearly as surprising for Wednesday's decision by the Federal Reserve's Open Market Committee on beginning/not beginning to slow the pace at which the Fed is buying Treasurys and mortgage-backed securities? After all, the markets have had months to masticate any tapering in Fed purchases. You'd think the decision would be priced into financial assets by now.

I don't see much chance of a direct surprise. I think the big, liquid global markets—like those for Treasurys and currencies, such as the dollar, yen, and euro—have discounted a modest Fed taper sometime before the end of 2013. In a recent Bloomberg poll, 57% of investors say they don't expect a sudden change in the markets if the Fed does decide to start a taper on Wednesday. Their reason? They say they already anticipate a Fed taper.

I doubt that a Fed decision to taper this week or wait until October is going to produce more than a blip in the markets I've noted above, or in the big liquid developed economy stock markets.

But that doesn't mean I'm ruling out all chances of surprise.

I think we could get a surprise in less-liquid markets, which is where worry is most intense right now. That wouldn't require a change in the markets, just a continuation of recent direction.

And that reaction could circle back to the globe's biggest asset markets. I doubt that's likely, or that any move in developed markets would be big or long-lasting. But that's definitely where I'd be looking for any surprise in the last half of this week.

Let me take you on a brief tour of potential surprises.

The Fed is currently buying $85 billion in Treasurys and mortgage-backed assets each month, in order to lower medium-term interest rates. (The Fed controls short-term interest rates directly and has said that it will keep short-term interest rates at their current "extraordinarily" low level of 0% to 0.25% until 2015. The Fed has been trying to lower medium term rates in the vicinity of seven-year maturities.)

The consensus is that the Fed, whenever it begins to taper, will do so very modestly, cutting back purchases from $85 billion a month to $75 billion or so. The first surprise, then, would be if the size of the Fed taper significantly exceeded $10 billion. A drop to, say, $70 billion, would be aggressive, but probably not enough to rattle the consensus. A drop to a level lower than that would indeed be a surprise, and would undoubtedly lead to a selloff in both the bond and stock markets. I think the likelihood of a drop on that action is abundantly clear to the Federal Reserve.

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And that's why this surprise is so unlikely. The US central bank wants markets to get used to the idea of a gradual withdrawal of stimulus. That's what's been happening for the last three or four months, as bond prices have fallen and yields have climbed. On September 13, the yield on the 10-year Treasury closed at 2.88%. That's up from 1.87% a year ago. In that period, though, US stocks have continued to climb. The Fed wouldn't mind an increase in 10-year yields to slightly over 3%, or a mild correction in US stocks on the order of the 4% to 5% pullback in August. But the Fed doesn't want to whack the markets hard and risk endangering the US economic recovery.

The Fed will begin a taper in 2013 because it has signaled markets to expect that move and anything else would damage the bank's credibility. But the bank doesn't want to move so fast and hard that it risks the modest economic recovery that it has helped engineer.

Much more likely, but still not extremely likely, is a surprise in the mix of what the Fed buys. The current program buys $45 billion a month in Treasurys and $40 billion a month in mortgage-backed assets. To the degree that there is a consensus on how the Fed might balance a taper, it points to leaving purchases of mortgage-backed assets alone and reducing purchases of Treasurys.

That consensus rests on a couple of points. One is the belief that the Fed sees the housing sector as a key to keeping the economy in recovery mode and doesn't want to see mortgage rates rise. And second is the belief that the Fed is feeling uncomfortable with its current holdings of Treasurys, as Ben Bernanke and Co. have virtually become the market for these medium-term maturities and would want to increase the market supply of these maturities.

This consensus will probably turn out to be correct, but greater-than-expected reductions in the Fed's purchases of mortgage-backed securities—whatever greater-than-expected might turn out to be—could temporarily spook mortgage REITs and housing stocks. I doubt that the Fed will increase any reductions in purchases of mortgage-backed securities in future tapering, so I'd see any panic on a possible Wednesday surprise in this sector as an opportunity for a short-term trade.

Emerging markets seem most likely to turn a Fed taper on Wednesday into a surprisingly big deal. That's because emerging markets are already worried about cash outflows and weakening currencies versus the US dollar. And because any suggestion that the Fed might be beginning on the road to an eventual end to its bond purchases, will set some investors and traders in these markets wondering when the Federal Reserve might begin to raise short-term interest rates.

I know. I know. The Fed has said it will keep short-term rates at current low levels until 2015. And Summers' withdrawal from the race to succeed Bernanke has removed the candidate most likely to have moved faster than Bernanke toward tightening.

But emerging markets are worried, and it would not take much to push them into contemplating—and worrying—about the unthinkable, an earlier-than-expected end to the 0% to 0.25% short-term rates at the Fed.

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In recent days we've seen the beginnings of what looks like a division of emerging markets into two groups:

First, those with more than adequate reserves and decent prospects for steady, or even, modestly increasing growth. The financial markets in these economies—China and Brazil, for example—have actually rallied recently. As of the close on September 13, Hong Kong's Hang Seng Index was up 16% from its June 24 low and the Shanghai Composite was up 14%.

In the second group are emerging economies with big current-account deficits, reserves that are relatively modest relative to those deficits, and economies that look like they're headed for more slowing, with a growth recovery uncertain.

Here the biggest worry is India, but Indonesia also belongs in this camp. India's BSE Sensex is down 12% this year in dollar terms, on a drop in the Indian rupee to a record-low of 68.45 to the dollar on August 28.

If the Fed does indeed begin a taper of its asset purchases on Wednesday, that could be enough to set off another round of selling in the weakest emerging markets. These markets seem extraordinarily sensitive to sentiment on a taper—Indian stocks traded in Singapore, which open for trading before stocks in Mumbai—were up 1.6% in early morning trading on Monday on the news of Summers' withdrawal.

That's a big move in Indian stocks on speculation about who will become the next Fed chairman.

Contagion from weakness in India and/or Indonesia might work this way—by spreading to other emerging-market areas of concern, such as Turkey, and then by focusing attention on the problems in Brazil and China that financial markets have decided to overlook in the last couple of weeks.

For example, China's economy shows signs of overheating that are remarkably like those that led the government to tighten credit—and thus to send Chinese stocks into retreat. Real estate prices in Beijing and Shanghai rose 14% in July from July 2012. New extensions of credit almost doubled in August from the previous month. Aggregate financing was 1.57 trillion yuan ($257 billion), well above the 950 billion yuan expected by analysts surveyed by Bloomberg.

To me, that sounds like China's growth problem isn't fixed and that bank lending and asset prices may soon be out of control again—at least to a degree that would require tightening by the People's Bank.

Right now investors and traders seem inclined to overlook that possibility. It wouldn't take all that much of a negative showing in Indian, Indonesian, and Turkish markets to refocus their attention. And if China's markets started to wobble again, I'd expect Australia and other export economies to show nerves too, and for Japan, the eurozone, and the United States to take notice.

How likely is this last surprise? As you can see from the length of the chain of causation that I've had to specify, it's not highly likely. The Fed would have to spook India, which would have to spook China, which would have to spook US markets.

But as I noted, the withdrawal of Summers from the running for Fed chair should remind us that surprises do happen.

I suspect that Wednesday's Fed news won't cause a huge ripple in the financial markets. But I am keeping my eye on the surprise horizons that I've outlined here.

And don't worry: If the Fed doesn't produce any market-rattling responses on Wednesday, we've still got the battles over the US budget and the debt ceiling to look forward to.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. Click here for a full list of the stocks in the fund as of the end of June.